Joseph Schumpeter famously argued that the essence of capitalism was creative destruction, by which new economic structures are born from the rubble of older ones. The government stress tests on the 19 largest US banks, the results of which are due be announced on Thursday, could have facilitated this process. The opportunity looks likely to be missed.The tests, which measure how viable banks are under adverse economic conditions, have no “failed” category, even if as many as 10 are reported to need additional capital. But, given that the economic environment already reflects the tests’ worst-case scenario and that recent estimates by the International Monetary Fund of financial sector losses have doubled in six months, the stress test results will not be credibly interpreted as a sign of bank health.

Instead, market participants will conclude that banks requiring extra capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help.

Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.

The results of the government’s stress tests on banks, to be released in a few days, will not mark the beginning of the end of the financial crisis. If we are to believe the leaks, the results will show that there might be a few problems at some of the regional banks and Citigroup and Bank of America may need some more capital if things get worse. But the overall message is that the sector is in pretty good shape.

The supersonic Concorde aircraft was considered in the 20th century to be the most sophisticated airliner, flying at twice the speed of sound. Its crash in Paris on July 25 2000 destroyed this confidence. Some blamed the crash on metal fragments from another aircraft; others argued that Concorde was overweight and unbalanced. The accident led to some design modifications but in 2003 Concorde was in effect jettisoned in favour of subsonic aircraft, much slower but easier to maintain.

It is not too much of a stretch to compare the global financial system of the pre-subprime era to Concorde. It was fiercely innovative and grew at a record pace for close to two decades, only to suffer a new type of hard landing without clarity as to whether it was the fault of the system’s pilots or also of those regulating its maintenance.

Secretary Geithner’s financial plan calls for stress tests at the large complex financial institutions (LCFIs). These tests are due to start this week. They will involve estimates on the eventual losses due to default on a wide variety of assets.

The U.S. banking system is close to being insolvent, and unless we want to become like Japan in the 1990s — or the United States in the 1930s — the only way to save it is nationalization.

As free-market economists teaching at a business school in the heart of the world’s financial capital, we feel downright blasphemous proposing an all-out government takeover of the banking system. But the U.S. financial system has reached such a dangerous tipping point that little choice remains. And while Treasury Secretary Timothy Geithner’s recent plan to save it has many of the right elements, it’s basically too late.

There are many cracks in the financial system, some of which we now know, others no doubt we will discover down the road. The eighteen white papers and executive summaries of each chapter of New York University Stern School of Business book, “Restoring Financial Stability: How to Repair a Failed System”, forthcoming this March by John Wiley & Sons, and contributed to by 33 of our faculty members, describe a relevant issue at hand and corresponding regulatory proposals. A common theme of our proposals notes that fixing all the cracks will shore up the financial house but at great cost. Instead, by fixing a few major ones, the foundation can be stabilized, the financial structure rebuilt, and innovation and markets can once again flourish.

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section V: The Role of the Fed

Background Systemic risk is the risk that the failure and distress of a significant part of the financial sector reduces the availability of credit which in turn may adversely affect the real economy. Not all economic downturns involve systemic risk, but the occurrence of systemic risk has almost invariably transformed economic downturns into deep recessions or even depressions. Such systemic risk has been ubiquitous in the current crisis. It has manifested itself in the moral hazard encouraged by “too-big-to-fail” guarantees, in the externalities created by deleveraging, fire-sales, hidden counter-party risk and liquidity shortages, and in the aggregate decline in home prices.

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency

Background

Derivatives are financial contracts whose value is derived from some underlying asset. These assets can include equities, bonds, exchange rates, commodities, residential and commercial mortgages. The more common forms of these contracts include options, forwards/futures and swaps. A considerable portion of financial innovation over the last 30 years has come from the emergence of derivative markets. Generally, the benefits of derivatives fall into the areas of (i) hedging and risk management, (ii) price discovery, and (iii) enhancement of liquidity. Even in the current financial crisis, the derivative scapegoat, credit default swaps (CDS), has played some positive roles. For example, CDSs enabled lenders to hedge their risk and offer loans. When the securitization market for loans, bonds and mortgages shutdown in the summer of 2007, a number of financial institutions were left holding large loan portfolios. Using the CDS market, some of these financial institutions smartly hedged out their risk exposure. In addition, CDSs and other credit derivatives have played a very important role in disseminating information to both the public and to regulators: from judging the quality of financial firm’s bankruptcy prospects in a remarkably prescient way, from providing credit risk estimates that were central to the U.K. government’s bailout plan, and from revealing in early 2007 declines in values of subprime-backed assets.

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section III: Governance, Incentives and Fair-value Accounting

Background

The unprecedented government bailout of financial markets and firms in the current crisis has forced executive compensation in banking and finance into the open. As Paul Volcker noted last April, “The bright new financial system—for all its rich rewards and unimaginable wealth for some—has failed the test of the marketplace by repeatedly risking a cascading breakdown of the system as a whole.” Taxpayers wonder how highly paid banking “talent” could have been instrumental in creating a financial disaster of epic proportions. And having been forced to take equity stakes in most of the largest US and foreign financial firms and guarantee their debt, taxpayers naturally feel that they ought to have a say in how such people, now in publicly supported private institutions, get rewarded. The defenders of privately determined approaches to compensation in financial institutions might wish otherwise, but this is now a high-profile political issue in the US and elsewhere, inexorably intertwined with re-stabilization of the financial system.

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section III: Governance, Incentives and Fair-value Accounting

Background

The large, complex financial institutions (LCFIs) are highly levered entities with over 90% leverage. This highly-levered nature makes them prone to excessive leverage- and risk-taking tendencies. By and large LCFIs also have explicit deposit insurance protection and almost always an implicit too-big-to-fail guarantee. The presence of such guarantees – often un-priced and at best mis-priced – has blunted the edge of the debt monitoring that would otherwise exert an important market discipline on risk-taking by these firms. Although there is mounting evidence pointing to weaknesses in equity governance of these firms, the high leverage they have undertaken and the failure of their internal risk management practices also suggest weakness and failure of regulatory governance.